How to Keep Inventory and Receivables Balanced

Originally published: 08.01.12 by
Ruth King

Check these ratios
monthly to detect problems with collections and materials.

For the past three months, I’ve written about the liquidity
ratios (Can you pay your bills?); the
debt ratios (Are you taking on too much
debt?); and percentage compensation, (How
productive are your employees?)

This month I’ll examine the last category of financial
ratios — inventory days and receivable days. These ratios answer the questions,
Do I have a collection problem, and am I
building up too much inventory?

These ratios are calculated by using values from the balance
sheet and the profit-and-loss statement. I also calculate inventory days
differently from the “textbook” definition of inventory days. That version
calculates the inventory days using material expense only. I include total cost
of goods sold. In the HVAC industry, when companies sell a part, they sell the
labor to install the part. Any time a company has material expense, it also has
a labor expense. Thus, the ratio as I calculate it ensures profitable use of
inventory by the field employees.

The inventory days and receivable days are calculated from
the inventory turns and receivable turns. The days trends are what you need to
watch each month.

The receivable-days ratio must be looked at in

conjunction
with the accounts-receivable-to-payables ratio. If the receivable-to-payables
ratio is increasing, and the receivable days are increasing too, then the
company has a collection problem. If the receivable-to-payables ratio is
increasing and the receivable days are constant, then the company is becoming
more profitable. The reverse is also true: If the receivable-to-payable days
are decreasing and the receivable days are constant, then the company is
becoming less profitable.

Table 1 shows the inventory and receivable ratios that I
track each month for a contractor. It is hard to decipher what is happening in
this company just looking at the numbers.

Graph 1 shows the graph of the inventory and receivable
ratios. Both the receivable days and inventory days increase and decrease each
month. It’s hard to see what is happening because there are months where the
accounts receivable days are as high as 100, and other months as low as 30. The
inventory days also range.

Table 2 shows the trailing data points for the turns and
days ratios. Graph 2 shows the trailing data for these ratios.

The trailing data graph for this contractor shows a good
story for inventory usage and a warning for receivable days. Inventory usage
remains fairly constant on a long-term basis, which means that the company is
being efficient with inventory. It is not building up inventory on a long-term
basis.

However, the receivable days show a different story. The
company has a collection problem. The fact that receivable days hit 100 days
during a month is definitely a warning sign that someone had to start calling
overdue accounts. The long-term trend is still rising. Even though the
receivable-to-payables ratio is decreasing, (see my May 2012 HVACR Business column), the company’s
receivable-days ratio is a warning sign to continue collection efforts. This
ratio will eventually start decreasing on a long-term basis as the monthly
receivable days start decreasing.

The last thing to look at is ensuring that the receivable
days are higher than the inventory days, as they are with this contractor. This
means that your company doesn’t have too much inventory. If both receivable
days and inventory days are under 30 days, as they are with many residential
contractors, there may be months where the receivable days are higher than
inventory days and vice versa. Just ensure that they both stay under 30 days.

Take 15 to 30 minutes each month to calculate the 10
operating ratios I’ve written about over the past four months. Calculating the
trends is critical to ensuring that your company can pay its bills, isn’t
carrying too much debt, doesn’t have a collection problem, and is productive.

Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at ruthking@hvacchannel.tv or 770.729.0258.

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